In
macroeconomics
Macroeconomics (from the Greek prefix ''makro-'' meaning "large" + ''economics'') is a branch of economics dealing with performance, structure, behavior, and decision-making of an economy as a whole.
For example, using interest rates, taxes, and ...
, a flexible exchange-rate system is a
monetary system
A monetary system is a system by which a government provides money in a country's economy. Modern monetary systems usually consist of the national treasury, the mint, the central banks and commercial banks.
Commodity money system
A commodity m ...
that allows the
exchange rate
In finance, an exchange rate is the rate at which one currency will be exchanged for another currency. Currencies are most commonly national currencies, but may be sub-national as in the case of Hong Kong or supra-national as in the case of ...
to be determined by
supply and demand
In microeconomics, supply and demand is an economic model of price determination in a Market (economics), market. It postulates that, Ceteris paribus, holding all else equal, in a perfect competition, competitive market, the unit price for a ...
.
Every
currency
A currency, "in circulation", from la, currens, -entis, literally meaning "running" or "traversing" is a standardization of money in any form, in use or circulation as a medium of exchange, for example banknotes and coins.
A more general def ...
area must decide what type of exchange rate arrangement to maintain. Between permanently fixed and completely flexible, some take heterogeneous approaches. They have different implications for the extent to which national authorities participate in
foreign exchange market
The foreign exchange market (Forex, FX, or currency market) is a global decentralized or over-the-counter (OTC) market for the trading of currencies. This market determines foreign exchange rates for every currency. It includes all aspec ...
s. According to their degree of flexibility, post-
Bretton Woods Bretton Woods can refer to:
*Bretton Woods, New Hampshire, a village in the United States
**Bretton Woods Mountain Resort, a ski resort located in Bretton Woods, New Hampshire
*The 1944 Bretton Woods Conference, also known as the "United Nations Mo ...
-exchange rate regimes are arranged into three categories:
*Fixed-rate regime:
currency union
A currency union (also known as monetary union) is an intergovernmental agreement that involves two or more State (polity), states sharing the same currency. These states may not necessarily have any Economic integration#Stages, further integratio ...
s,
dollarized
Currency substitution is the use of a foreign currency in parallel to or instead of a domestic currency. The process is also known as dollarization or euroization when the foreign currency is the dollar or the euro, respectively.
Currency subs ...
regimes,
currency board
In public finance, a currency board is a monetary authority which is required to maintain a fixed exchange rate with a foreign currency. This policy objective requires the conventional objectives of a central bank to be subordinated to the exchan ...
s and conventional
currency peg
A fixed exchange rate, often called a pegged exchange rate, is a type of exchange rate regime in which a currency's value is fixed or pegged by a monetary authority against the value of another currency, a basket of other currencies, or another m ...
s
*Intermediate regimes: horizontal bands,
crawling peg
In macroeconomics, crawling peg is an exchange rate regime that allows depreciation or appreciation to happen gradually. It is usually seen as a part of a fixed exchange rate regime.
The system is a method to fully use the key attributes of the ...
s and crawling bands
*Flexible regimes: managed and independent
floats
All monetary regimes except for the permanently fixed regime experience the
time inconsistency
In economics, dynamic inconsistency or time inconsistency is a situation in which a decision-maker's preferences change over time in such a way that a preference can become inconsistent at another point in time. This can be thought of as there be ...
problem and exchange rate
volatility, albeit to different degrees.
Fixed rate programs
In a
fixed exchange rate
A fixed exchange rate, often called a pegged exchange rate, is a type of exchange rate regime in which a currency's value is fixed or pegged by a monetary authority against the value of another currency, a basket of other currencies, or another m ...
system, the monetary authority picks rates of exchange with each other currency and commits to adjusting the money supply, restricting exchange transactions and adjusting other variables to ensure that the exchange rates do not move. All variations on fixed rates reduce the
time inconsistency
In economics, dynamic inconsistency or time inconsistency is a situation in which a decision-maker's preferences change over time in such a way that a preference can become inconsistent at another point in time. This can be thought of as there be ...
problem and reduce exchange rate volatility, albeit to different degrees.
Under ''dollarization''/''Euroization'', the
US dollar
The United States dollar (symbol: $; code: USD; also abbreviated US$ or U.S. Dollar, to distinguish it from other dollar-denominated currencies; referred to as the dollar, U.S. dollar, American dollar, or colloquially buck) is the official ...
or the
Euro
The euro ( symbol: €; code: EUR) is the official currency of 19 out of the member states of the European Union (EU). This group of states is known as the eurozone or, officially, the euro area, and includes about 340 million citizens . ...
acts as legal tender in a different country. Dollarization is a summary description of the use of
foreign currency
A currency, "in circulation", from la, currens, -entis, literally meaning "running" or "traversing" is a standardization of money in any form, in use or circulation as a medium of exchange, for example banknotes and coins.
A more general def ...
in its capacity to produce all types of money services in the domestic economy. Monetary policy is delegated to the anchor country. Under dollarization exchange rate movements cannot buffer external shocks. The money supply in the dollarizing country is limited to what it can earn via exports, borrow and receive from emigrant remittances.
A ''currency board'' enables governments to manage their external credibility problems and discipline their central banks by “tying their hands” with binding arrangements. A currency board combines three elements: an exchange rate that is fixed to another, “anchor currency”; automatic convertibility or the right to exchange domestic currency at this fixed rate whenever desired; and a long-term commitment to the system. A currency board system can ultimately be credible only if central bank holds official foreign exchange reserves sufficient to at least cover the entire monetary base. Exchange rate movements cannot buffer external shocks.
A ''fixed peg'' system fixes the exchange rate against a single currency or a currency basket. The time inconsistency problem is reduced through commitment to a verifiable target. However, the availability of a
devaluation
In macroeconomics and modern monetary policy, a devaluation is an official lowering of the value of a country's currency within a fixed exchange-rate system, in which a monetary authority formally sets a lower exchange rate of the national curren ...
option provides a policy tool for handling large shocks. Its potential drawbacks are that it provides a target for
speculative attack In economics, a speculative attack is a precipitous selling of untrustworthy assets by previously inactive speculators and the corresponding acquisition of some valuable assets (currencies, gold). The first model of a speculative attack was contain ...
s, avoids exchange rate volatility, but not necessarily persistent misalignments, does not by itself place hard constraints on monetary and fiscal policy and that the credibility effect depends on accompanying institutional measures and a visible record of accomplishment.
Monetary union
A currency or monetary ''union'' is a multi-country zone where a single monetary policy prevails and inside which a single currency or multiple substitutable currencies, move freely. A monetary union has common monetary and fiscal policy to ensure control over the creation of money and the size of government debts. It has a central management of the common pool of
foreign exchange reserves
Foreign exchange reserves (also called forex reserves or FX reserves) are cash and other reserve assets such as gold held by a central bank or other monetary authority that are primarily available to balance payments of the country, influence ...
, external debts and exchange rate policies. The monetary union has common regional monetary authority i.e. common regional central bank, which is the sole issuer of economy wide currency, in the case of a full currency union.
The monetary union eliminates the time inconsistency problem within the zone and reduces real exchange rate volatility by requiring multinational agreement on exchange rate and other monetary changes. The potential drawbacks are that member countries suffering asymmetric shocks lose a stabilization tool—the ability to adjust exchange rates. The cost depends on the extent of asymmetric costs and the availability and effectiveness of alternative adjustment tools.
Flexible exchange rate
These systems do not particularly reduce time inconsistency problems nor do they offer specific techniques for maintaining low exchange rate volatility.
A ''
crawling peg
In macroeconomics, crawling peg is an exchange rate regime that allows depreciation or appreciation to happen gradually. It is usually seen as a part of a fixed exchange rate regime.
The system is a method to fully use the key attributes of the ...
'' attempts to combine flexibility and stability using a rule-based system for gradually altering the currency's par value, typically at a predetermined rate or as a function of
inflation
In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reductio ...
differentials. A crawling peg is similar to a
fixed peg; however, it can be adjusted based on clearly defined rules. A crawling peg is often used by (initially) high-inflation countries or developing nations who peg to low inflation countries in attempt to avoid currency appreciation.
At the margin a crawling peg provides a target for speculative attacks. Among variants of fixed exchange rates, it imposes the least restrictions, and may hence yield the smallest credibility benefits. The credibility effect depends on accompanying institutional measures and record of accomplishment.
''
Exchange rate bands'' allow markets to set rates within a specified range; edges of the band are defended through intervention. It provides a limited role for exchange rate movements to counteract external shocks while partially anchoring expectations. This system does not eliminate exchange rate uncertainty and thus motivates development of exchange rate risk management tools. On the margin a band is subject to speculative attacks. It does not by itself place hard constraints on policy, and thus provides only a limited solution to the time inconsistency problem. The credibility effect depends on accompanying institutional measures, a record of accomplishment and whether the band is firm or adjustable, secret or public, band width and the strength of the intervention requirement.
''
Managed float
Managed float regime is an international financial environment in which exchange rates fluctuate from day to day, but central banks attempt to influence their countries' exchange rates by buying and selling currencies to maintain a certain rang ...
'' exchange rates are determined in the
foreign exchange market
The foreign exchange market (Forex, FX, or currency market) is a global decentralized or over-the-counter (OTC) market for the trading of currencies. This market determines foreign exchange rates for every currency. It includes all aspec ...
. Authorities can and do intervene, but are not bound by any intervention rule. They are often accompanied by a separate nominal anchor, such as an inflation target. The arrangement provides a way to mix market-determined rates with stabilizing intervention in a non-rule-based system. Its potential drawbacks are that it does not place hard constraints on monetary and fiscal policy. It suffers from uncertainty from reduced credibility, relying on the credibility of monetary authorities. It typically offers limited transparency.
In a
''pure float'', the exchange rate is determined in the market without public sector intervention. Adjustments to shocks can take place through exchange rate movements. It eliminates the requirement to hold large reserves. However, this arrangement does not provide an expectations anchor. The exchange rate regime itself does not imply any specific restriction on monetary and fiscal policy.
References
{{Reflist
Coudert, Virginie, Cécile Couharde and Valérie Mignon, "Exchange rate flexibility across financial crises",http://www.cepii.fr/PDF_PUB/wp/2010/wp2010-08.pdf
Foreign exchange market